Marginal income tax rates are at an historical all-time low. Our Government debt is at an all-time high and currently 17.5 trillion dollars. Ten thousand baby boomers are retiring every single day. Social Security is expected to only be able to pay .77 cents for each dollar of scheduled benefits by the year 2033, and we have recently overhauled the health care system, which is likely to cost us all a lot of money as we shift health care responsibility from individuals to the government. These are just a few of the reasons that so many people are considering tax planning as part of their overall financial well being, and these are some of the reasons why I’ve recently converted more of my traditional IRAs to Roth IRAs. But what about those who have both pre-tax and post-tax contributions inside of a traditional IRA. Should an investor convert the post-tax contributions to a Roth?
One of the questions I am getting asked more and more these days has to do with the mechanics for conversions from a traditional IRA to a Roth IRA. As you probably know a traditional IRA is typically funded with pre-tax dollars and defers taxation into the future while a Roth IRA is funded with post-tax dollars and future distributions are, in most instances, free from federal income tax. So should you be deferring taxes into the future given the reality of our current economic conditions or not?
I recently consulted with a person who had made both pre-tax and post-tax contributions to his IRA. He was interested in converting only the post-tax portion of his IRA to a Roth.
Before I get too deep into the weeds, let me explain that most individuals can make contributions to an IRA, but depending on the amount of income they have will determine if the contribution is tax deductible in the year they make the contribution or not. A pre-tax contribution is money that was contributed to the IRA and was not taxed at the time of the contribution. Pre-tax contributions are what the majority of people contribute to an IRA.
A post-tax contribution is where the individual already paid taxes on the income received and made a contribution to their IRA, but did not receive a tax benefit in the year of the contribution. This usually occurs for high income earners and they may also be precluded completely from being able to contribute to a Roth IRA. For example a married couple filing a joint tax return in 2014 covered under a workplace retirement plan will have tax deductions phased out for contributions to an IRA when their income is between $96,000 – $116,000. That same married couple not covered by a workplace retirement plan will have tax deductions phased out when contributing to an IRA when their income is between $181,000 – $191,000, and a married couple filing jointly with a modified adjusted gross income of more than $191,000 is ineligible to contribute to a Roth.
If all of the money being considered for conversion to a Roth IRA was in traditional IRAs and was pre-tax dollars, then the rules are very clear and easy to understand. You simply pay tax on the amount you convert in the year you convert.
Things get a little more complicated when you have both pre-tax and post-tax contributions to a traditional IRA since it is not possible to convert only the post-tax contributions of a traditional IRA to a Roth IRA. The IRS has a pro-rata rule that requires you to add the value of all your IRAs and determines what percentage is post-tax vs pre-tax. Then when you convert dollars from your traditional IRA to a Roth IRA, a portion of the conversion is considered taxable and a percentage is not taxable based on the pro-rata formula.
For example, you had a rollover IRA with $90,000 of pre-tax contributions and a traditional IRA with $10,000 of post-tax contributions. The IRS would require you to add $90,000 + $10,000 = $100,000 of total IRA assets. Then you divide $10,000 / $100,000 and find that 10% of the IRA assets would be considered tax free upon conversion. So if you were to then convert just the post-tax traditional IRA of $10,000, then the IRS would consider 10% of that IRA conversion to be post-tax money and 90% to be pre-tax. On the $10,000 dollar conversion, $9,000 would be taxable as ordinary income and $1,000 would not be taxable.
When consulting with people on these rules they sometimes express frustration and feel this is unfair and double taxation because they have already paid tax on the $10,000 in the post-tax traditional IRA. I understand why people feel this way however these are how the IRS rules work, and the IRS uses the sum of all your IRA accounts and does not view them independently of one another for the purpose of converting traditional IRAs to a Roth IRA.
When people have both both pre- and post-tax IRA contributions, they should track the basis of the post-tax contributions in their traditional IRA using form 8606 when filing their taxes every year. This way they will know how much of their future distributions will be taxable vs tax free when they begin taking money out of their retirement accounts.
When I was growing up my dad used to teach us to delay gratification. To eat our vegetables first and dessert last. One of my favorite quotes is from Jim Rohn who said, “All men will experience pain. The pain of discipline or the pain of regret. The pain of discipline weighs an ounce compared to the pain of regret that weighs a ton.” Paying taxes now may not be fun, but I have a feeling paying taxes in the future might really be painful.
Everyone of us are lucky to live in the greatest country in the world and most people I know don’t mind paying their fair share of taxes. For a lot of people it makes sense to diversify future tax liabilities. In my mind converting a traditional IRA to a Roth IRA is the equivalent of eating your vegetables first and saving the dessert for later. I personally really like the idea of a tax-free retirement.
This article was also featured in the July 2014 Kitsap Peninsula Business Journal.
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